Austerity in the UK

‘Expansionary fiscal contraction’ is the phrase du jour in economics these days. It has replaced the old buzz word ‘austerity’ with which it is synonymous. What it means is reducing government spending to make the economy grow. Expansionary fiscal contraction is voodoo economics. It doesn’t work.

This policy will reduce aggregate demand by reducing the government’s spending.

The question is what happens in the private sector. The financial sector balances sum to zero. Let’s assume we don’t see a huge fall in the dollar’s value that boosts exports more than the dollar value of imports. Then the adjustment falls to the private sector to make up for the reduction in the government sector’s deficit. A reduction in government spending could be met by a reduction in the private sector’s net surplus that fills the demand gap via business capital spending, consumer releveraging, etc. Or the private sector surplus remains about the same and the economy contracts. Remember, households have bloated balance sheets. If we assume that people are trying to draw down on their debt and increase their savings, it is reasonable to believe that the government’s reduction in spending will be met by a reduction in private sector spending.

People like Hugh Hendry get it. He is not advocating fiscal contraction because he believes it will immediately be expansionary. Instead, he argues there is no policy remedy for debt deflation. Rather than allow the government’s debt levels to climb and fill in the missing private sector demand as Richard Koo advocates, Hendry recommends just letting aggregate demand fall and starting anew. That leads to Depression of course.

This is risky advice. The dynamics of a world in depression are extremely volatile. This is an ideological question that has a lot to do with one’s view of the role of government. But, make no mistake, cutting government spending across a broad swathe of countries at the same time reduces spending in a way that increases short-to-medium term budget deficits and increases the likelihood of another banking panic.

The UK is a good example of what austerity means. In the wake of tax increases and budget cuts in the UK, retail sales in Britain have plunged by the most on record. I seriously doubt that the coalition government there will meet its deficit cutting goals with so many people still out of work. The good thing is that UK is but one country. Moreover, inflation played a key role in creating the mess there. And it is not clear yet that inflation will continue to be as much of a problem going forward. Nevertheless, when we get the same sorts of policies in the U.S., things will be different. The U.S. is a much bigger economy and the loss of that level of spending will have far-reaching consequences.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

Withdrawal of the government’s taking over of private debt addition will result in a contraction of GDP, no matter whether it is done by raising taxes, cutting spending, or some combination of the two.

He is also making the Hugh Hendry point, that Austrian types make, when he says:

“”busts” must occur in which debt and output are brought back into balance. We call that process by which the weakest borrowers and lenders go bankrupt and clear the economy “recession”, and when it is intentionally delayed, obfuscated, covered over and tampered with, it becomes more and more severe the longer attempted denial of basic arithmetic continues.”

The question is whether stimulus actually aids the private sector in deleveraging as Koo says it has in Japan or whether it really is a transfer of private sector debt onto the public sector. Much of this has to do with economic growth during the period of deleveraging. I think this is largely an ideological point, meaning it depends on your view of the role of government and the efficacy of government spending. You could argue it both ways.

Thanks for the reply Edward. I’m very much a lay person on this – currently trying to get a decent perspective on the various “schools” – Austrian/MMT/neoclassical/post-Keynesian etc and appreciate your balanced non-idealogical approach.

jimh009 says 8 years ago

Hi Edward,

I agree that much of this debate is ideologically based, but I have a very hard time agreeing with the view stimulus aids private sector deleveraging except for, perhaps, in the very short term (like one year or so). From where I sit, all I see is a massive expansion of public sector debt that will, eventually, have to be dealt with in one fashion or another. In short, I see the policy of moving private sector debts to the public sector as nothing more than a delaying tactic. The debt still remains and will have many negative affects that are likely to be long lasting.

Public sector insolvency is never a good thing. Far better to suffer a sharp but relatively short depression due to private sector deleveraging then have the public sector slowly go bankrupt (ultimately leading to a depression, too, among other nasty potential things).

I guess I agree with Denninger that credit booms always end with busts. The borrowed money allowed GDP to be enhanced during the credit boom years. Common sense suggests when the credit boom ends that a long period of deleveraging will follow, leading to slower growth and/or a contraction in GDP.

Simple math makes it impossible to have it both ways. All government borrowing does is delay the inevitable.

Withdrawal of the government’s taking over of private debt addition will result in a contraction of GDP, no matter whether it is done by raising taxes, cutting spending, or some combination of the two.

He is also making the Hugh Hendry point, that Austrian types make, when he says:

“”busts” must occur in which debt and output are brought back into balance. We call that process by which the weakest borrowers and lenders go bankrupt and clear the economy “recession”, and when it is intentionally delayed, obfuscated, covered over and tampered with, it becomes more and more severe the longer attempted denial of basic arithmetic continues.”

The question is whether stimulus actually aids the private sector in deleveraging as Koo says it has in Japan or whether it really is a transfer of private sector debt onto the public sector. Much of this has to do with economic growth during the period of deleveraging. I think this is largely an ideological point, meaning it depends on your view of the role of government and the efficacy of government spending. You could argue it both ways.

Thanks for the reply Edward. I’m very much a lay person on this – currently trying to get a decent perspective on the various “schools” – Austrian/MMT/neoclassical/post-Keynesian etc and appreciate your balanced non-idealogical approach.

Anonymous says 8 years ago

Hi Edward,

I agree that much of this debate is ideologically based, but I have a very hard time agreeing with the view stimulus aids private sector deleveraging except for, perhaps, in the very short term (like one year or so). From where I sit, all I see is a massive expansion of public sector debt that will, eventually, have to be dealt with in one fashion or another. In short, I see the policy of moving private sector debts to the public sector as nothing more than a delaying tactic. The debt still remains and will have many negative affects that are likely to be long lasting.

Public sector insolvency is never a good thing. Far better to suffer a sharp but relatively short depression due to private sector deleveraging then have the public sector slowly go bankrupt (ultimately leading to a depression, too, among other nasty potential things).

I guess I agree with Denninger that credit booms always end with busts. The borrowed money allowed GDP to be enhanced during the credit boom years. Common sense suggests when the credit boom ends that a long period of deleveraging will follow, leading to slower growth and/or a contraction in GDP.

Simple math makes it impossible to have it both ways. All government borrowing does is delay the inevitable.

I understand what you are saying. The problem is economic nationalism, which rises in periods of economic turmoil. I will post on this.

Anonymous says 8 years ago

What do you think of John Mauldin’s unemployment chart in his latest email: The Curve in the Road? I get a sense that the narrative he’s hinting at is something like: “the aggregate (demand) loss from the unemployed might not be a big deal because it is structured around less educated people who also (causally) earn less. And, in fact, unemployment is very low among educated people who earn more.”

I thought it was an interesting chart but my interpretation of that data on AD would be that the AD effect of a loss of lower skilled workers might be greater since they spend a disproportionate amount of income. What I heard Mauldin saying was that inflation could feed through into wage gains even with high unemployment because there is less slack in some segments of the employment market.

Don’t know about household debt broken out by quintiles.

Anonymous says 8 years ago

What do you think of John Mauldin’s unemployment chart in his latest email: The Curve in the Road? I get a sense that the narrative he’s hinting at is something like: “the aggregate (demand) loss from the unemployed might not be a big deal because it is structured around less educated people who also (causally) earn less. And, in fact, unemployment is very low among educated people who earn more.”

I thought it was an interesting chart but my interpretation of that data on AD would be that the AD effect of a loss of lower skilled workers might be greater since they spend a disproportionate amount of income. What I heard Mauldin saying was that inflation could feed through into wage gains even with high unemployment because there is less slack in some segments of the employment market.